A new “Backgrounder on Education” was released by the Heritage Foundation on March 25, 2013. Entitled Official Education Spending Figures Do Not Incorporate Full Cost of Teacher Pensions, the new report claims that the Federal government “dramatically underestimates” teacher pension costs in its official education spending figures, and that correcting the problem could add tens of billions of dollars—about $1,000 per pupil—to official education spending estimates.The report’s author, Jason Richwine, is the Heritage Foundation’s senior policy analyst in empirical studies, specializing in education policy, public-sector compensation and labor issues. He also wrote another Heritage Foundation report, along with Andrew Biggs from the American Enterprise Institute (AEI), entitled Assessing the Compensation of Public-School Teachers. (This report claimed that public-school-teachers’ total compensation (including benefits) was 52 percent greater than fair market levels indicate they should be, given the “relative lack of rigor of education courses” -- meaning that “many teachers have not faced as demanding a college curriculum as other graduates” -- and the “low cognitive ability compared to other college graduates” that active teachers exhibit.)
Richwine’s latest report asserts that the Federal government’s incorrect education spending estimates are due to the fact that the National Center for Education Statistics (NCES), a division of the U.S. Department of Education, permits states to define teacher pension costs as the amount school districts contribute to their pension funds each year. However, Richwine argues that since governments “frequently underfund their pensions,” the reported amount does not really reflect the “true” costs of these pensions, and that the “correct accounting” would measure pension costs based on the present value of future pension benefits that teachers have accrued.Of course, Richwine also insists that this “correct accounting” approach would also use a discount rate based on a virtually risk-free rate of return, such as the yield on U.S. Treasury bonds of around 3 percent currently, instead of the pension accounting method that he notes “detractors might call … an accounting trick” that bases the discount rate on the expected rate of return on plan investments. This latter approach, Richwine say, is “roundly rejected by financial economists, private pension administrators, and public-sector pension regulators in other industrialized nations.”
Consequently, Richwine argues, government actuaries discount future pension liabilities at a rate that is too high. If the current numbers used by the NCES were replaced with both the risk-adjusted normal cost and the payments toward unfunded liabilities, the cost of overall benefits would go up by 78.8 percent, according to Richwine, and official total expenditures-per-pupil would rise from $12,309 to $14,054 during the 2009–2010 school year, which is the most recent year for which data are available.Therefore, Richwine recommends that the NCES should begin measuring the cost of pensions with actual risk-adjusted pension liabilities rather than annual contributions. He says that this would provide more accurate estimates of teacher pension costs and of education spending in general.
Richwine devotes much time to discussing how many economists agree that the only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate. He says that this is a “basic principle of financial economics,” and that economists “practically unanimously support” this method.He goes so far as to point out that in a 2012 poll, 38 of 39 leading economists agreed with this statement: “By discounting pension liabilities at high interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.” Richwine asserts that therefore, “defenders of public pension accounting methods, not their critics in mainstream economics, are the embattled contrarians.”
With all due respect to economists, they are not always right. Indeed, Paul Krugman, an economist and winner of the 2008 Nobel Memorial Prize in Economic Science, has pointed out that economists can indeed make mistakes. In a September 2, 2009 article in The New York Times entitled How Did Economists Get It So Wrong? Mr. Krugman discussed how so few economists saw the 2008 economic crisis coming.Mr. Krugman noted that “During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right.” “There was nothing in the prevailing models,” he observed, “suggesting the possibility of the kind of collapse that happened” in 2008. The problem, he went on to say, was that the economics profession “went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.”
So too, perhaps, with the discount rate controversy? The financial economics model for the discount rate may work beautifully for critics of public sector defined benefit plans when, as now, there is a very long period of very low interest rates. It can make it appear that plans are discounting future pension liabilities at too high a rate. Consequently, critics argue, basing the discount rate on the expected return on plan investments systematically understates the costs of funding public pension plans.However, what happens when interest rates are very high? Does the “truth” of Mr. Richwine’s assertions still hold? For example, 30-year Treasury yields (as of the June valuation date) were almost at 14% in 1982 and 1984. Between 1978 and 1985 they were consistently above 8%. During such periods, would financial economists continue to insist that a discount rate based on expected rates of return understates the costs of funding plans? Would 38 of 39 leading economists still agree that by discounting pension liabilities at the expected rates of return, many U.S. state and local governments were understating their pension liabilities and the costs of providing pensions to public-sector workers?
Basing the discount rate on the risk-free rate of return during periods of high interest rates could make plans look much better funded than they actually are. Contribution rates could fall below those based on expected rates of return, and could exacerbate underfunding problems when interest rates drop.I am not an economist, but it seems to me that for a theory to be useful -- in practice and not just in theory -- it should work regardless of whether a risk-free rate is at historic lows, as it has been now for several years, or in the double digits, as it may well be in the future depending upon inflation.
Just consider me an “embattled contarian.”